Are Search Funds Displacing Private Equity?

Are Search Funds Displacing Private Equity?

Private equity has dominated the world of mergers and acquisitions for years now. Tech companies hoping to build and sell have been counseled to cater to the whims of private equity firms, and that advice has generally proven sound. But PE may not be the future of tech M&A. A new report from Axial found that the role of PE funds in lower middle market companies fell dramatically, from an average of 28.4% at the start of 2020 to 15.4% last quarter. Search funds, meanwhile, are gaining ground.

The Expanding Role of Search Funds

Search funds are picking up steam. When grouped along with individual investors and holding companies, they represented a third of all new M&A activity in the third quarter of 2022. And there was an overall increase in search fund activity of 37% between the third quarter of 2021 and the third quarter of 2022.

Search funds offer more flexibility to smaller businesses, which may help explain their growth in the lower middle market. They work by bringing together a small group of entrepreneurs together to buy small businesses, then grow them. In many cases these entrepreneurs are young and eager to invest, and therefore more flexible. According to Axial, the average revenue ranges of the companies these funds target is between $50 and $100 million, though other industry sources suggest a broader range of $10 million to $250 million.

Why Work with a Search Fund?

Owners planning a sale must choose the option that offers the best terms for the highest price, and may also need to consider the total effort the sale demands. In this regard, search funds offer many benefits. They pool together talent and resources, and the investors then play a daily role in operations. For people who dislike the idea of a faceless PE firm owning their business, search funds offer more direct involvement.

Search firms are a popular landing spot for freshly graduated MBAs. These investors tend to be excited about their next venture, and eager to get involved in daily operations. These attributes make them a great match for smaller businesses and may offer some peace of mind to owners with an emotional attachment to their company.

Search funds may be the ideal buyer for businesses that:

  • Are relatively small, new, or both.
  • Have a straightforward business model.
  • Have been told by other buyers that their business is too small.
  • Want the business to continue growing.
  • Do not like the PE model, or worry that PE will destroy their business.

Types of Search Funds

In general, there are three types of search funds, each of which is steadily growing:

  • PE-backed search funds are the most popular. They raise capital from lower middle market partners, then use it to purchase lower middle market companies.
  • Corporate search funds seek to acquire small businesses in specific niches. They’re sponsored by larger corporations.
  • Venture capital search funds are similar to PE search funds, but raise cash from venture capitalists rather than PE firms.

The flexibility and agility of search funds and their focus on sustainable growth and cash flows makes them attractive for investors and may be a good option for some owners who are planning to sell.